Welcome to the main investment method Business Analysis or fundamental analysis.
The key idea of fundamental analysis is to analyze the stock for what is really is, a business.
In simple terms, this can be known as Business Analysis. Ultimately, when we buy a stock, we are in fact buying the business itself. To purchase an entire business can be very costly, so what the stock market provides for us, is the chance to buy a percentage of the business. By buying the shares of a business, we become part owner of the business along with the other shareholders.
So some questions arising with regard to buying business.
- Which business should I buy?
- When should I buy them?
- When should I sell them?
- Where do I even begin?
Let us walk you through the foundation thinking behind these questions.
Business Analysis, Business Questions.
Let’s approach the first important question:
- Which business should I buy?
Allow us to prompt you to thinking before giving you some answers…
Imagine you have some savings (We hope that this imagination correlates to your actual life…) and you want to begin investing. You told your friends about your desire to invest and make your money grow. And if you have experienced such an instance before, you will realize that once you have money and announce that you want to invest, you will receive more business investment proposals that you ever wanted.
Let’s continue this story as you meet up with one of your friend who had been in business for some time. He wants to source for more funds to expand his operations and invites you to invest into his business and become a shareholder. Now, what will your decision be? To invest or not to invest?
At this point we want to draw the linkage of this example to that of investing in the stock market. When we approach the stock market with some amount of money, we can imagine that each stock that is listed up there on the stock exchange is akin to our friend who is inviting us to become a shareholder and invest into the business.
So back to the question, which business will we buy into?
The answer is one that is simple: We only buy into businesses, which we are confident that it can continue to make money for the shareholders for many years to come.
You will realize that we highlighted some parts of the statement to the answer:
- Make Money
- Many Years to Come
Think about it for a moment, it makes sense, doesn’t it?
Do you want to invest into a business that cannot make money for its shareholders?
Do you want to invest into a business that only makes money for a short period of time than goes bust?
Of course we want a business that can make money and have the ability to sustain its ability to make money. The reason is simply because ONLY when a business continues to make money, then can it pass the money back to its shareholders. Without the ability to make money, it has nothing to pass back to its shareholders.
Before we touch on the portion of how then, can we be Confident that the business presented to us is going to make money now and in the long run, we just want to build on the issue of how a business passes on its profit back to its shareholders. The need to understand this is foundational and very important to any investor.
How Does A Business Pass Profits Back to Its Shareholders
Whenever a business makes money after paying off all their expenses, including taxes, this is known as the net profit. All of us should be interested how much Net Profit our business makes because this gives us a good idea on how much our money has grown. (In chapter 3, we will discuss more into understanding business fundamentals. )
But does a business always return all the Net Profits back to its shareholders every year? If they do, things would be very simple. But in the real world of business, we found out that this is usually not the case.
The most tangible and obvious way in which a business passes back the profits to its shareholders is by giving back certain portion of the profits back in cash. This is known as dividends.
The rest of the remaining portion is kept. This is known as Retained Earnings because the business “retains” that portion of the “earnings”. (Isn’t accounting simple and intuitive…? Well, we will hold our comments on that.)
One important question we need to ask ourselves is “How does the portion of the retained earnings eventually flow back to me as a shareholder?”
The answer lies with how the business uses the retained earnings. Typically speaking the business uses the retained earnings to expand its operations. This potentially mean higher net profits and higher dividends in the future. This may also potentially mean that the business will be worth much more in time to come and this will drive the price of the business up. But remember, this is only if the retained earnings are use appropriately and if the expansion plans are successful. This leads the third part – our confidence in the business.
Whether you like it or not, in any forms of investments, judgment is needed. Even if you choose not to invest on your own, but pass the judgment to a professional investment manager, you are still making a judgment with regard to the manager. You may end up choosing either a Warren Buffett to invest for you or you may end up with a Mr Ponzi Scheme investor.
Asking Business Questions
Now that we understand that if we can pick a business that will continue to make money, we can make money too. This is what it means when we say we want our money to work for us. We take our money to exchange it for a piece of a business that will make more money in return.
But how do we choose a business which we know will make money? How can we predict the future of a business?
If I were to ask you whether a burger shop were to be able to last, without giving you any information other than it is a burger shop, will you be able to make a sound judgment? Of course not.
So how can we confidently invest into a good business? Our answer is by asking the right questions. We want to find out enough information to allow us to make an informed and intelligent decision. When Warren Buffett bought his first share (GEIKO) after learning from his professor, he went all the way to the office on a Saturday afternoon to ask questions about the business. Unfortunately for him, the office wasn’t open on Saturdays and fortunately for him, the CFO then was actually working on that day and was kind enough to sit Warren down and answer all his questions. And that was the beginning of his investment legend.
Now back to the example where your friend is offering you an investment opportunity into his business. What kinds of question will you ask? At this point, we can recognize that there isn’t information.
We will do an exercise to get you to list down at least 7 questions you want to ask regarding the business. After you write down some questions you will ask, you can compare it to some of the questions we will ask.
|Some business questions
What is the service or product provided by the business to its customers?
Who are the other competitors?
What is so special about the business’s service or products that will allow it to continue to gain customers?
Will the business be affected by technological changes?
How long as the business been in operations?
How much profits has it been making since the start of the business?
How often does business pay out its profits to its shareholders
Does the business have any debt?
What are the key risks of the business and what is the plan to address these risks?
Who are the people running the business and why are they chosen to run the business?
Now for the million-dollar (or even billion dollar) question: where do we find answers to these questions?
Let’s turn to our key source, the place where most of the answers to our questions can be found and sometimes even more – The Annual Report.
In our next posts, we will look into how to read the annual reports
Meet me live for more sharing,
Mind Kinesis Research Team